What Is Debt Settlement And How Does It Work?

Key takeaways

Debt settlement can be done on your own or through a third party, depending on your needs.
Risks include creditors not agreeing to settle and more damage to your credit score.
You may need to pay taxes on any amount settled, so talk to a tax professional before pursuing settlement.

Debt settlement is the process of negotiating with your creditors. You can do it yourself — or pay a third-party company to do it for you. It can be worthwhile for some, but debt settlement has its share of risks. Your credit score will almost certainly take a hit. Most importantly, your creditors may not agree to settle, leaving you with the same amount of debt as when you started.

What is debt settlement?

Debt settlement is when your debt is settled for less than what you currently owe with the promise that you’ll pay the amount settled for in full.

Sometimes known as debt relief or debt adjustment, debt settlement is usually handled by a third-party company, although you could do it by yourself. Not all lenders accept debt settlements, and there are some instances where it could cause more financial harm than good.

What is a debt settlement company?

A debt settlement company acts as a middleman between you and your lenders or creditors. The company negotiates on your behalf to reduce or eliminate your debt. Sometimes it can be helpful to have an experienced guide to help you through an unfamiliar process.

But before working with a debt settlement company, understand its process and read reviews about the company. Different debt settlement companies offer different terms — and many charge high fees — so be sure to do your research.

How does debt settlement work?

There are two ways to handle debt settlement: on your own or with the help of a debt settlement company.

DIY debt settlement

You can settle your debt by yourself. Reach out to your creditors and explain your financial situation. It will take time and persistence, but you may be able to lower the amount you owe, change your interest rate or come to another form of agreement. While you and your creditors find a solution, you will continue to make the payments you owe.

Debt settlement companies

A debt settlement company negotiates with your creditors. Often, it will require you to stop paying your creditors and make payments into a savings account. It will then use your money to pay your debt and collect the fees you owe. You may fall further behind on payments, and your credit score could plummet.

Risks of debt settlement

Debt settlement may seem like a convenient option, but the process has quite a few risks. In addition to finding a legitimate debt settlement company, you may need to wait years for your debts to be negotiated. Even if you do it yourself, you may not be able to avoid fees or a hit to your credit score.

You could face hefty fees

The fees associated with debt settlement services vary depending on local and state laws. It is not unusual for a third-party debt settlement professional to charge between 15 percent to 25 percent of the debt that gets resolved. That means if you’re seeking to settle a debt of $50,000, you’ll pay a fee based on that amount, not on the final negotiated repayment amount.

However, according to rules enacted by the Federal Trade Commission (FTC) in 2010, debt negotiation companies can only charge fees after they have resolved the debt. Any debt settlement company or attorney that tries to charge you before the debt is settled is not legitimate. Instead, find a reputable debt settlement professional who follows regulations.

Your credit score may be damaged

Going through the settlement process and resolving debt using this approach will likely negatively impact your credit score.

For instance, many debt settlement companies ask that you stop making payments on your credit card during negotiations. Lenders and creditors are not as likely to negotiate with consumers who can still make monthly payments on their bills. Not paying bills, of course, damages your credit.

“To settle, most creditors require that an account is in a delinquent status,” says debt attorney Leslie Tayne, founder of Tayne Law Group. “During the settlement process, an individual’s credit score will often take a hit while the accounts are in negotiation. This means you may also be sued.”

In addition, when accounts are marked as settled on credit reports, it can hurt your credit score.

Debt settlement is not as quick as you think

It is not unusual for the entire debt settlement process to take three to four years. Your attorney or debt settlement company will need time to negotiate with your creditors. The more creditors you have, the more time it will take. In addition, you will need time to build up the money in a savings account to pay off your debts in a lump sum.

The forgiven debt is taxable

While it may be a relief to settle your debt, and possibly for less than you originally owed, you may now be on the hook with the IRS. Any forgiven debt over $600 is taxable. So, if a debt settlement company can negotiate $10,000 worth of debt down to $7,000, you will owe taxes on the $3,000 forgiven by your creditor.

Ideally, the money you pay your debt settlement company should also be enough to cover applicable taxes. However, you will need to check the fine print of any agreement you sign. If taxes are not included, you will be responsible for paying the remaining debt, the debt settlement company’s fee and the taxes.

You may owe more than when you started

When you begin the debt settlement process, the debt attorney or third-party company will often advise you to stop making payments on your debt. Interest will still accrue on that debt.

You may also begin racking up late fees and other charges. Ultimately, these charges may increase your debt to more than was originally owed. This could add complexity to your settlement and result in you not getting the relief from debt you expected.

You may not be able to settle

Not all companies will settle your outstanding debt. And even if they do agree to settle, some refuse to work with debt settlement companies. If you’ve agreed to follow the debt settlement company’s terms and haven’t been keeping up with your payments, this could make it more difficult to come to an arrangement with your creditor. Worse, your creditor may pursue legal action against you, incurring more costs and further harming your credit.

Alternatives to debt settlement

If debt settlement doesn’t work for your scenario, you have other options.

Credit counseling

A nonprofit credit counseling agency can help you come up with a debt management plan that allows you to pay off your debt in circ*mstances that work best for your finances. Sometimes, credit counseling agencies will work similarly to debt settlement companies.

Some credit counselors have little to no cost for you, but you’ll make payments to them rather than to your creditors. You’ll usually close all outstanding accounts — like credit cards — until your debt is paid off.

Before starting, ensure that you’re working with an accredited agency, like American Consumer Credit Counseling, the National Foundation for Credit Counseling or Financial Counseling Association of America.

Debt consolidation

Debt consolidation is when you combine all your debt into one new loan to pay off. It can reduce the amount of outstanding interest you owe and lets you make one manageable payment per month rather than many.

You can use a nonprofit credit counseling agency to help you through debt consolidation or go through it on your own using a debt consolidation loan.

Balance transfers

A balance transfer is when you move your outstanding credit card debt to a new credit card that offers 0 percent APR for a set amount of time, usually between 12 and 24 months. This means you’ll be able to make low monthly payments without the extra cost of interest added to your outstanding balance every month. But once the 0 percent interest term ends, you’ll get charged interest on anything that isn’t paid in full every month.

The best balance transfer credit cards won’t charge a fee to transfer your outstanding balance. But keep in mind that not all balance transfer credit cards will transfer your full outstanding balance. This could mean that you’re on the hook for paying off your new balance and whatever didn’t transfer over.

Bankruptcy

Bankruptcy is usually considered a last resort, but depending on your circ*mstances, it may be a more attractive option.

Filing for Chapter 7 bankruptcy will remove most unsecured debt, like credit cards, medical debt or other types of loans, but won’t remove back taxes, student loan debt or child support. This type of bankruptcy can take a few months to complete, compared to a few years with debt settlement.

Neither option looks great on your credit report, but the sooner you remove or settle your debt, the sooner you can move on. If you want something faster, bankruptcy might be better than debt settlement.

Beware of debt settlement scams

While many companies look out for your best interest, some debt settlement companies are scams. Do your best to avoid fraud by checking accreditation and vetting any company you look into.

Avoid false promises: If a company says that it can make your debt go away and stop debt lawsuits and collections, beware. Debt settlement can be effective, but your creditor isn’t obligated to accept a settlement. Getting your debt and related problems to disappear is not a guarantee.
Never pay before settlement: If your debt settlement company requires money before it’s done any work, that’s a red flag. Read the fine print when it asks for payment, and make sure that you know what it’s going toward.
Keep up with communications: If your debt settlement company doesn’t tell you about the risks involved in debt settlement or the consequences of not making payments to your debt collectors, that’s a problem. You should know every risk before handing over your money (or pausing payments).

The bottom line

While debt settlement might sound like a great idea, it’s not always the best option for tackling your debt. Some creditors and debt collection agencies don’t work with debt settlement companies, and some don’t do settlements at all. And even if they do, it could take years before a settlement is reached. Imagine what waiting to pay multiple types of debt and the damage it could do to your credit during that time.

You have other options, including debt consolidation, debt management plans, credit card balance transfers and even bankruptcy. Evaluate all your options before deciding, and don’t be afraid to change course if debt settlement is not working out like you expected.

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